Another week, another piece of knowledge about macroeconomics. Interest rates are one of the absolute must-knows for an investor. In this entry, you will learn what interest rates are, how they affect different markets, and what you can do to make the best out of it, whether the rates are raising or falling. Let’s find out more about how interest rates affect the economy.
Table of contents:
1. What Are Interest Rates?
Interest rates represent the cost of borrowing money or the fee for using money. Rates are usually expressed as a percentage of the amount borrowed and are paid regularly. Central banks like the US Federal Reserve determine interest rates to control the money supply and inflation.
Interest rates can have a substantial impact on the economy:
- Lower interest rates make it cheaper for people to raise funds, which is known to stimulate economic growth by encouraging spending and investment. For instance, low-interest rates can make it more affordable for consumers to purchase homes or for businesses to invest in new machinery or expansion.
- In contrast, higher interest rates can dampen economic growth by increasing the cost of raising money. High-interest rates can also deter spending and investing, as consumers and businesses are less likely to borrow or make large purchases when it is more expensive to raise capital.
Interest rates may also impact the overall value of the currency as well as inflation. When interest rates are high, investors often flock to currencies as a safe haven, increasing their value. High-interest rates can also contribute to keeping inflation in check by making it costly for consumers and businesses to borrow money, thus reducing demand and slowing prices.
The takeaway is that interest rates directly affect borrowing, spending, and inflation, thus playing a vital role in the economy. Central banks, like the Fed, use interest rate policies to maintain economic stability and promote growth.
2. How Do Changes in Interest Rate Affect Different Markets
Since changes in interest rates affect a large portion of the economy, they naturally impact markets. However, changes in interest rates affect markets differently so it’s useful to understand their impact on each market.
2.1. How Do Interest Rates Affect the Stock Market?
A couple of things are known to occur when interest rates change. Rising interest rates, for example, can make fixed-income investments, such as bonds, more appealing to investors and draw them away from stocks. This, in turn, may lead to a decrease in stock demand, resulting in a price decline.
Higher interest rates can hinder growth-oriented investors, as they can decrease the potential for stock price gains. On the other hand, lower interest rates can improve the sentiment towards stocks, as they offer a greater potential return compared to bonds and other fixed-income investments.
Read also: How To Build a Stock Trading Strategy
2.2. How Do Interest Rates Affect the Bond Market?
The relationship between interest rates and bond prices is inverse, meaning that bond prices tend to fall when interest rates rise, and vice versa. The reason is that when interest rates rise, the newly issued bonds carry a higher yield, making existing bonds with lower yields less attractive to investors. Interest rate hikes can be a risk for bond investors because they can decrease the value of their bond holdings. On the flip side, lower interest rates can make bonds more appealing, as they promise higher returns.
Read also: How to Manage Risk When Trading
2.3. How Do Interest Rates Affect Currencies?
The rule of thumb is that higher interest rates make a given country’s currency more appealing to foreign investors, which can lead to an appreciation in its value. High-interest rates can serve as an incentive for foreign currency investors looking to earn a higher investment yield. On the other hand, low-interest rates can make a currency less appealing, leading to a depreciation in its value and making it riskier for foreign investors to put their money into it.
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2.4. How Do Interest Rates Affect the Real Estate Market?
Like many other markets, interest rate hikes can dampen the demand for real-estate purchases simply because raising and borrowing money becomes more expensive. This is enough to put negative pressure on consumers, thus increasing housing prices. For real estate investors, higher interest rates can be a problem, too, as they may reduce the potential for price gains. On the flip side, lower interest rates can make borrowing more affordable and boost demand for housing. This can lead to an upward shift in housing prices, creating an opportunity for real estate investors.
2.5. How Do Interest Rates Affect Commodities?
Changing interest rates may also impact commodity prices. Interest rate hikes may slow economic growth, reducing commodity demand. Interest rate hikes can hinder commodity investors because they can reduce price appreciation. Conversely, since lower interest rates can stimulate economic growth, they can also stimulate commodity demand.
2.6. How Do Interest Rates Affect Cryptocurrencies?
Interest rates can indirectly affect cryptocurrencies in several ways.
For example, when the economy is booming and the interest rates are low, investors may be more inclined to seek higher returns in generally considered riskier assets, such as cryptocurrencies. This sort of enthusiasm can boost the prices of cryptocurrencies.
Because interest rates are often used to control inflation, high inflation can increase demand for cryptocurrencies as a hedge against inflation. If investors believe that traditional currencies are depreciating due to inflation, they may look to invest in cryptocurrencies instead.
3. What Happens When Interest Rates Change?
There is plenty at play when it comes to changes to the economy. Remember that interest rates are just a piece of the whole puzzle. Below are a few examples of how interest rate variations can impact different elements of the economy and what they can mean for you as an investor.
3.1. How Do Rising Interest Rates Affect the Economy?
- Reduced borrowing and spending: Higher interest rates make borrowing more expensive for individuals and businesses, which can lead to reduced spending and investment.
- Housing market slowdown: Interest rate hikes can make mortgages and other loans less affordable, reducing demand for housing and lowering prices.
- Reduced demand for riskier assets: Higher interest rates can increase the yield on bonds and other fixed-income investments, making riskier assets like stocks and cryptocurrencies less attractive to investors. This can lead to reduced demand for stocks and lower stock prices.
- Difficulties for companies with high debt levels: Since interest rate hikes increase borrowing costs, they can reduce their profits and hurt their earnings. This is especially true for companies with high levels of debt.
- Currency appreciation: When interest rates rise, the value of money can also rise as investors seek higher returns.
3.2. How Do Falling Rates Affect the Economy?
- Increased borrowing and spending: Lower interest rates allow consumers and businesses to raise money at a lower cost, encouraging increased spending and investment.
- Stimulation of the housing market: Lower interest rates can make mortgages and other loans more affordable, potentially increasing the demand for housing and driving up prices.
- The incentive to invest in riskier assets: Lower interest rates can reduce the yield on bonds and other fixed-income investments, making riskier assets, such as stocks and cryptocurrencies, more attractive. This in turn, can trigger an increase in demand for stocks and a rise in stock prices.
- Improved business profits: Lower interest rates can cut the cost of borrowing, which can increase business profits and improve revenues. This can be especially beneficial for companies that have a significant amount of debt.
- Decrease in the value of money: When interest rates fall, the value of money may also follow suit as investors seek higher returns elsewhere.
3.3. What to Do When Interest Rates Rise
Below are a few examples of what you can do when interest rates rise and what you can do when they fall. Remember that the economic climate is never fully predictable, so make sure you do your due diligence before making any financial decisions. That being said, here are some good practices to consider when interest rates rise:
- Consider investing in bonds and other fixed-income securities that can offer higher returns when interest rates rise.
- Focus on companies with lower debt levels, as they may be less impacted by rising interest rates.
- Consider investing in conservative sectors, like utilities and consumer staples that may be better equipped to handle an economic downturn.
- As always, diversify your portfolio to include a variety of stocks and bonds, as well as investments in different industries and geographic regions.
3.4. What to do when interest rates fall
- Consider paying closer attention to growth stocks, as there might be an opportunity to benefit from an improving economy and increased consumer spending.
- Look for promising companies with high levels of debt, as they may benefit from lower borrowing costs and thus increase in value.
- Look into cyclical sectors, such as technology and consumer discretionary, which have historically performed especially well during periods of economic growth.
- Hold a portion of your portfolio in bonds and other fixed-income securities, which can provide stability during market fluctuations. Diversification, above all.
4. How Interest Rates Affect The Economy: Key Takeaways
Changes in interest can affect specific markets in different ways. As an investor, you should strive to develop an understanding of how interest rates impact different parts of the economy so that it becomes clearer to you as a whole. This knowledge translates into a wider understanding of the ins & outs of economic growth and stagnation, equipping you with the tools necessary to make well-grounded financial calls.
Before making investment decisions, the best thing to do is to follow the market and test your skills through a demo trading account. That way, you can see where you stand in understanding the market without losing your hard-earned money.
Keep in mind that the impact of interest rate changes can be complex and may vary depending on several factors, including the state of the economy and the overall level of interest rates.